Revisiting “Hedged” High Yield

We have written in the past about some of the concerns we had the with “hedged high yield” strategy (see our blog), whereby investors go long high yield bonds and short Treasuries (or Treasury futures).   As we noted in our prior writings:

We see another big problem with a combined portfolio of being long high yield bonds and short Treasuries: during times of systemic market disruptions we see a “flight to quality” trade, where investors abandon perceived “risky” assets such as high yield bonds and pile into “risk free” Treasuries.  So in a situation like this, you would not only be hit on a decline in your high yield bonds as investors sell them, but you would be hit on your short Treasury position as investor flock to these assets and bid up the price of Treasuries.  So at face value the “hedge” sounds appealing, but it very well may be far from a hedge depending on the market environment.

History has told us this was the case and we are in the midst of seeing it play out. The recent market re-pricing in both equities and fixed income, has sent the high yield bond market down. And in the midst of this we have seen yields in Treasury bonds collapse, with the yield on the 10-year Treasury ending 2013 over 3% and now touching below 2% this morning. So in this case, you are getting a double hit. Investors beware…

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Why High Yield, Why Now

Here are some of the reasons we believe that the high yield bond market looks attractive at current levels:

  • MODERATE RISK:  With default being the primary risk for high yield bonds and bank loan investing, we see no systemic default spike on the horizon, as maturities have been largely pushed out to 2017 and beyond1, companies have maintained reasonable discipline through this cycle, and capital markets remain functional, with CLO issuance setting records and high yield new issues continuing to print.

MaturitiesThe current projections are for default rates to remain at about half of their historical level through the next couple years.2

Defaults

  • ATTRACTIVE SPREADS:  With much of the secondary high yield market having been indiscriminately sold, we are now back to spread levels of 527bps on the index.3  This compares to historical median spread levels of 519bps over the last nearly 30 years.4  So we are at median spread levels, but with a well below average default outlook.  While a portion of the index continues to trade at tight spreads to call prices, we are seeing plenty of bonds at 750 basis points, or more, over the 5-year Treasury, which is among the best we’ve seen when combined with overall risk outlook.
  • U.S. FOCUS:  Most high yield companies, and specifically our general area of focus in the mid-sized issuers, are largely domestically focused, which can serve to avoid some of the headwinds of a stronger U.S. dollar impacting exports and the conversion of foreign profits and weakening economic activity in other areas of the world, both of which we expect to be a drag on broad multinational companies and thus the major stock market averages.
  • ALPHA POTENTIAL:  The high yield and floating rate loan markets have dramatically expanded, now at $3 trillion, allowing active investors to work to create value through a variety of mechanisms, just like in a stock investing, including:
    • Industry exposure—Strategically allocating to an industry we see as undervalued.
    • Capital structure positioning—Secured or subordinate securities, taking advantage of what we see as the best risk/return potential within a company’s capital structure.
    • Yield-to-Call—“Cushion” bonds for which we expect a near-term call.
    • Avoiding negative convexity—Avoiding securities at large premiums over call prices.
  • VOLATILITY: Volatility can create a great entry point, as often the average retail investor sells on emotion rather than fundamentals, thus creating potential opportunities for active managers to put on positions at a discount in individual securities within their portfolios, but also potential opportunities for those investing in these funds.
  • APPEALING VALUE:  The high yield market provides what we see as attractive, tangible income to investors.  As we had mentioned, we are seeing plenty of opportunities at 750bps above the 5-year Treasury, which is now sub 1.5%, so if you theoretically could build a portfolio with a yield of 9%, and a default rate of 2%, with a recovery rate of 40% (the historical average)5, we are looking at a theoretical loss rate of 1.2% and a risk-adjusted yield of 7.8%.6  This compares to 1.5% on the 5-Year Treasury, 2.2% on the 10-Year Treasury, 2.89% on investment grade, and 1.99% on the municipal bonds.7  On a relative value, we believe the high yield market offers very compelling value.
1  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  October 3, 2014, p. 9.
2  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  October 3, 2014, p. 11.  As noted, the current default rate excludes the impact of TXU.
3  Index referenced is the Credit Suisse High Yield Index.  The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.  Data sourced from Credit Suisse, as of 10/14/14.
4  Historical spread data covers the period from 1/31/1986 to 9/30/2014.
5  The last 37 years of data have shown a recovery rate of 42.85%.  Blau, Jonathan, James Esposito, and Daniyal Khan. “2014 Leveraged Finance Outlook and 2013 Annual Review,” Credit Suisse Global Leveraged Finance. February 6, 2014, p. 217
6  HYPOTHETICAL ONLY.  These calculations assume that credit spreads remain constant and do not factor in any fees or expenses or changes in price movements for other reasons, including security fundamentals, etc. Actual results may be materially different.  Default rates based on projected trends but actual results may be materially different.
7  U.S. 5  and 10 Year Treasury Note is sourced from the U.S. Department of Treasury, Daily Treasury Curve Rates. Investment Grade yield to worst based on the Barclays Corporate Investment Grade Index, which consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital).  Municipal yield to worst based on the Barclays Municipal Bond Index, which covers the long-term, tax-exempt bond market (source Barclays Capital). All data as of 10/14/14.
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Peritus at the Inside Fixed Income Conference

Peritus’ Tim Gramatovich will be speaking at the panel “High Yield: When Does Crowded become Over-Crowded” at the Inside Fixed Income Conference, being held at The Island Hotel in Newport Beach, California on October 22nd.

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Upcoming TV Appearance

Tim Gramatovich, Chief Investment Officer at Peritus, will be a guest on the PBS “Nightly Business Report,” with Tyler Mathisen and Susie Gharib (available on-line and local PBS stations), for Thursday, October 2, 2014 to discuss the recent movements and opportunities in the energy and commodity markets.

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Market Conditions and Investment Strategy

Markets are funny beasts. Efficient? Perhaps. Manic? Always. What has been going on since everyone came back from the beach is quite simple: risk off. There has been a quiet but vicious downdraft in both credit and small cap equities which has really been hidden by those following the Dow and the S&P 500. As high yield bond spreads have widened dramatically over the last month to levels not seen in over a year, we believe this provides an attractive entry point into high yield corporate debt. To see our full commentary on current market conditions and how we are investing accordingly, click here.

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High Yield Market Technicals

It has been a long quiet period in credit but volatility has returned with a vengeance. I have had an opportunity to discuss this with a number of our institutional clients in recent days, but there are a few factors that are exacerbating the recent price declines in the high yield bond market. To cut to the chase, most importantly for investors, we see this as representing a fantastic opportunity to buy this market aggressively on the cheap and capture a liquidity premium created by the law of unintended consequences. With over thirty years of experience in this market, I do not see it as a value trap or a fool’s errand. Nobody is making the case that a huge default cycle is about to begin in either the high yield or loan market, so from our perspective the fundamental fears are fairly non-existent. It does not mean that we won’t see defaults. We certainly will, as evidenced by the biggest failure of all Texas Utilities (aka Energy Future Holdings). But these remain a very, very small percentage of the overall high yield market which is now approaching $1.7 trillion. We have the Fed (Yellen and Fisher) barking at the moon, talking about risk in the high yield market. My best guess here is that they are trying to warn the market of impending rate increases. They surely cannot be talking about fundamentals of corporate high yield debt issuers, which they would have no idea about. My advice is for them is to talk with the investment grade corporate and mortgage community which have much more significant exposure to higher rates. Our asset class is among the lowest duration among the major fixed income sub-groups.1 We have written chapter and verse on why we see rates going nowhere so let’s leave that alone for now.

Let’s turn our attention back to the law of unintended consequences. Post the 2008 carnage, governments across the globe have been working overtime to “reduce” systemic risk in the financial system. What they have done is created a series of regulatory mechanisms (Basel III, Dodd-Frank and Volcker) that has penalized any type of risk taking. This includes market making activities for all the major banks/broker dealers. So what we have is very thin secondary markets. What has happened recently is that significant selling has been met with low-ball bids or none at all. The bonds in many cases have to experience “price discovery,” whereby investors such as Peritus and others become the market. Said another way, there are brokers but no dealers.

This is not really a surprise to anyone, but this is one of the first stress tests in bondland since the new regulations have taken hold. While there is short term pain involved, we see the potential ability to capture sizable liquidity premiums and buy discounted bonds as incredibly attractive and very timely. Attractive because we don’t believe that anything fundamentally has changed. With the recent and substantial widening of spreads, we believe it is simply a matter of time before institutional investors re-allocate monies to our asset class and the liquidity premium and overall spreads tightens back to much lower levels.

1 See our blog “High Yield Bonds and Interest Rates” for actual comparisons of durations of investment grade, municipal, and high yield markets.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income or equity securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
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Oil Market Dynamics

Oil is down the most in 22 months today. Brent Crude fell more on the day than West Texas Intermediate (WTI) and it primarily comes back to the unexpected supply increases out of Libya (being at the highest level in over a year), as well as weak economic data from China and Europe potentially curtailing demand. The market is currently viewed as being well supplied with no clear bomb set to explode in the visible future. US production continues to grow and Iraq hasn’t had any problems with production lately, despite the ISIS presence there. The other usual suspects, such as Nigeria, have also been relatively subdued. As a consequence we are seeing oil slump. However, Brent futures for November are about $3.00 higher than today’s levels, which is still lower relative to prices we have seen so far this year, but not at nearly 2-year lows like we’re at today; the point being that the market doesn’t really believe that prices will last at these levels. Production is back from Libya today but could easily be gone tomorrow. We see a lot of upside price risk in the market.

OPEC dictates oil prices and honestly we don’t know what the reaction to these low levels will be from OPEC. They might cut production. The Iranian minister was on TV the other day saying it’s time for OPEC to cut, but the Saudi’s are the ones who for all intents and purposes make the decision, and they are seemingly none too happy with how they have been treated by Obama. As such this may be an opportunity to squeeze the US energy sector a little. They also may be tired of being the swing producer. Nobody knows for sure, but history shows us that they will likely step in with efforts to boost pricing.

Our research has shown that production from unconventional sources such as shale, deepwater exploration and oil sands mining require $90-100 oil to make a modest return. These unconventional barrels have become a critical source of supply for the world. As such we can’t expect prices to drop below these levels for very long or the projects simply aren’t economical, in turn likely impacting supply and ultimately driving prices back up.

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A Look at Concerns Impacting the High Yield Market

Be it interest rate concerns or talk of a bond bubble, the high yield market has faced a step back over the past couple weeks. We’ve addressed the interest rate concerns at length—see our piece “Strategies for Investing in a Rising Rate Environment” and blog “Is This Time Different?”—and at the end of the day, history would indicate that high yield bonds have historically performed well during a rising rate environment.

Turing to the bond “bubble” talk, let’s look at the 2005-2007 period when we really did see concerning conditions in the high yield bond market. Looking at the Credit Suisse High Yield Index as a proxy for the market, we saw spreads break 400bps in July 2005 and stay under this level until bottoming out at 271 bps in May 2007.1 This is a far cry off of the spread of 475bps that we sit at today.2 And while concerns have recently been raised about loosening underwriting standards and a pick-up in “covenant lite” activity in the loan world, we certainly aren’t seeing the lack of discipline across the board as we saw in 2005-2007, where deals were getting down at massive multiples (many of which have since proved unstainable) and we saw telling signs like an abundance of PIK (pay-in kind versus cash interest pay) and dividend deals. Over recent years, market issuance has been dominated by refinancing rather than this sort of activity and transaction multiples for M&A have been relatively tame. So, this isn’t 2007 and we don’t see conditions that warrant labeling the high yield market a “bubble” that should be avoided. If anything, the volatility that we have seen over the past few months speaks to rationality—markets can’t continually go up and we would see a periodic step back as healthy.

We’ve heard lots of other reasons why we are seeing sellers in the market, and there seems to be some inconsistencies in some of these reasons. I’ve heard the concern that if rates do rise, that could lead to a set-up in defaults. A couple things to keep in mind: generally we see rates rising during periods of stronger economic activity. We would think that for a substantial rise in rates to happen, we would need to see the economy improve off of where we are today. That doesn’t mean that we won’t still potentially see the Fed take short term rates up little next year at some point, but we would expect that for this Fed to make a big move, they would certainly need to see improved economic conditions, especially in areas such as unemployment and underemployment. And on the flip side, if those strong economic conditions are there by mid-2015 and beyond, then that is a benefit to corporate credit as we would presumably see improved financial prospects for these companies…and one would then think improving financial prospects would in turn equate to lower defaults.

Maybe this is an obvious statement, but the other thing to note as we think about defaults is that higher rates don’t necessarily mean that costs get more expensive for high yield bonds issuers—high yield bonds are fixed rate securities and the fact that so much of the market has refinanced bonds over the past few years and locked in low rates (saving on interest costs) positions them well to manage through the environment ahead. And with the fixed coupon on these securities, that helps keep free cash flow cash generation steady.

On the flip side, potentially higher interest rates mean that companies needing to refinance would face likely higher rates to do so—but again, we don’t see a massive spike in rates on the horizon so that could well mitigate this issue. Additionally, it is important to keep in mind the amount of bond maturities over the coming years. As you can see from the chart below, of the $1.6 trillion market, we only have a very small portion maturing between now and 2018/2019 when maturities start to pick up, so this bodes well for any sort of refinancing risk in the near-term as we seemingly have years of runway.3

Blog 9-29-14

Turning to another issue we have seen mentioned several times over the past week or two: concerns are being raised that companies are focusing on more shareholder friendly activities, such as using cash for stock buybacks. While yes, that can be an issue, there are other caveats to consider. For instance, while we never like to see cash go out the door for stock buybacks or dividends, we often see this occurring in companies that are generating good cash flow that they want to do something with—and free cash flow generation is virtually always a positive. As a bond holder, it is also important to keep in mind that these sorts of equity-focused actions can easily be turned off should that cash flow be threatened. Additionally, active managers can avoid the credits where the company is levering up to unsustainable levels or using cash they don’t have to spend to fund these shareholder friendly activities.

Finally, some also attribute the recent selling pressure in the high yield market to global weakness and a general risk-off trade. Also mentioned are certain industries under severe pressure. This seems more of a rationale argument, as we can’t deny that we are certainly seeing economic weakness in certain areas of Asia and Europe, not to mention the issues in the Middle East, Russia, and Western Africa. But we argue this is why we view active management as so essential. Active managers can avoid names that would have large exposures to these areas facing weak economic activity or other geopolitical issues, and focused more on North American-focused companies, which makes up the predominant portion of the high yield space. And active management is equally important in assessing industries under pressure. Our experience has been that industries facing challenges can actually create opportunities for active managers that can parse out the strong players that they view as undervalued and likely destined to benefit from a change in the competitive landscape, from the weak players that are likely destined for failure.

At the end of the day, we don’t see a sizable interest rate hike on the horizon unless we were to see a strong recovery in the economy, and if that is the case then we believe high yield corporate credit stands to benefit from the improved economy and has historically managed rising rates well (again see our piece “Strategies for Investing in a Rising Rate Environment” for historical data points and further detail). Certainly we don’t see a rising rate scenario as an automatic trigger for defaults to quickly spike—defaults generally increase during times of systemic issues, which we don’t see on the horizon, not to mention the forward maturity schedule is very manageable. We feel that the recent selling pressure creates an even better entry point in terms of purchasing credits and can help to increase potential yield and capital gain generation for investors.

1 The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.
2 The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. Level as of 9/25/14.
3 High yield market size of $1,588 billion, Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  June 27, 2014, p. 5.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income or equity securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
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Duration-Based Investing: Yield Matters

It would be hard to have missed the call in the fixed income space for “short duration” products over the last year.  Duration is a measure of interest rate sensitivity (the percentage change in the price of a bond for a 100 basis point move in rates), so the lower the duration the theoretically less sensitive those bonds are to interest rate movements.  Lower duration bonds would not eliminate the interest rate impact, just lessen it.  We see this as a good strategy broadly speaking if you are talking the high yield asset class versus the investment grade asset class, with the high yield market naturally having a much lower duration.  However, we believe this strategy is lacking when it is used to parse out the high yield space itself, investing in only the lower duration names within the high yield category.

This gets back to the concept of yield.  In a box, this sounds like a good strategy, but you need to factor in the starting yield on the portfolio to mathematically assess if practically speaking this is the right strategy.  If you were to invest according to a “short duration” strategy in the high yield market, let’s hypothetically say you could achieve a portfolio with a duration of 2.0 years, so a 100 bps change in rates over 6mos would mean that the price of your portfolio would theoretically decline by 2.0%.  If your starting current yield on the portfolio was 6.5%, meaning you theoretically generate 3.25% of income over that 6mos, then you are looking at a theoretical net gain of 1.25% (3.25% – 2.0%) over the period of rising rates.  However, if you can build a portfolio in the high yield bond and loan market investing according to both maximizing yield and considering duration, let’s say you can build a portfolio with a duration of 2.5 years and a current yield of around 9%.  In this case, your theoretical sensitivity to a 100bps movement over 6mos would be a price change of 2.5%, but you would be theoretically generating 4.5% of income over the 6mos, so your net theoretical gain would be 2.0%.  If that 100bps interest rate movement is over a year instead of 6 months, that yield benefit gets even larger, putting you at a theoretical net gain of 4.5% for the hypothetical short duration portfolio versus a theoretical gain of 6.5% for the higher yielding portfolio.1  And of courses, if rates don’t move or even decline from current levels, then the higher yielding portfolio would not only benefit from the higher starting yield but a theoretical positive price movement per the duration calculation.

We believe this demonstrates that investing purely according to a short duration strategy and not factoring in yield is not necessarily the wisest way to approach this environment.  At the end of the day, yield matters.  A higher yield can go a long way in making up for relatively small differences in duration.  Furthermore, even if rates do rise, it very well can take longer than many expect, making the argument for the higher yielding portfolio versus the purely short duration portfolio even stronger.

For more on the high yield market’s historical performance during periods of rising rates and the current strategies in place, and their deficiencies, to address a potential rising rate environment, see our updated piece, “Strategies for Investing in a Rising Rate Environment.”

The duration and price movement relationships are approximates and calculations are provided for illustration only.  These calculations assume that credit spreads remain constant and do not factor in any fees or expenses or changes in price movements for other reasons, including security fundamentals, etc.  Actual results may be materially different.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income or equity securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.

 

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Peritus in the News

Peritus was featured in the article “Why I Own HYLD” by Heather Bell in ETF.com’s “ETF Report,” September 2014, p. 26.

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